| Cost accounting is the process of tracking, | | | | commissions or casual workers) and very high |
| recording and analyzing costs associated with the | | | | fixed costs (interest payments, salaries, |
| products or activities of an organization, where | | | | insurance). |
| cost is defined as 'required time or resources'. | | | | As a result, the terms "direct costs" and "indirect |
| Costs are measured in units of currency by | | | | costs" often replace the variable/fixed |
| convention. Cost accounting could also be defined | | | | terminology, to better reflect the way allocation |
| as a kind of management accounting that | | | | of overhead is actually calculated. Indirect costs |
| translates the Supply Chain (the physical | | | | (often large) are usually allocated in proportion to |
| movement of products) into financial value to | | | | either direct costs, or some physical resource |
| support decision making to improve costs and | | | | utilization. |
| cash flows. | | | | One effect of the above is that the practice of |
| There are at least four approaches: Standard | | | | allocating fixed costs has a far more distorting |
| Costing, Activity-based Costing Marginal Costing | | | | impact on unit cost figures than it ever used to |
| Throughput Accounting Origins Costs were | | | | have. |
| originally considered fixed. | | | | For example: say the railway coach company paid |
| ("Cost" comes from a Latin root meaning "to | | | | its workforce a fixed monthly rate of $8000 |
| stand".) In larger organizations, some costs tend | | | | (total) and its other fixed costs had risen to |
| to remain the same even during busy periods, | | | | $2600/ month making the total fixed costs = |
| while others rise and fall with volume of work. A | | | | $10600/month. The unit cost to make 40 |
| more convenient way of categorizing these costs | | | | coaches per month is still $325 per coach ($60 |
| is to define them as either fixed or variable. Fixed | | | | material + (10600/40)), while 100 coaches would |
| costs were associated with the business | | | | have a unit cost of $166 per coach ($60 + |
| administration, and did not change during quiet or | | | | ($10600/100)), and 10 coaches would "cost" $1120 |
| busy times. | | | | each. Managers using the unit cost figure based on |
| Variable costs were associated with productive | | | | 20 coaches per month ($60 + ($10600/20) or |
| work, and naturally rose and fell with business | | | | $590) would likely reject an order for 100 |
| activity. | | | | coaches (to be produced in one month) if the |
| In the early twentieth century, as organizations | | | | selling price was only $300 per unit. If they used |
| began getting more complex, managers needed a | | | | the original fixed/ variable cost distinction, they |
| simple way to make decisions about products and | | | | would see clearly that this order contributes to |
| pricing. | | | | the fixed costs by $240 per coach ($300 - $60 |
| Since most costs at the time were variable, | | | | materials) and would result in a net profit of |
| managers could simply total the variable costs for | | | | $13,400 (($240 x 100) - 10600). |
| a product and use this as a rough guide for | | | | Activity-based costing Activity-based costing |
| decision-making. | | | | (ABC) is costing by activities. In this case, |
| For example: In order to make a railway coach a | | | | activities are those regular actions performed |
| company needed to buy $60 in raw materials and | | | | inside a company. "Talking with customer |
| components, and pay 6 laborers $40 each: total | | | | regarding invoice questions" is an example of an |
| average variable costs of $300. Knowing that | | | | activity performed inside most companies. |
| making a coach required spending $300, managers | | | | Accountants assign 100% of each employee's |
| therefore couldn't sell below that price without | | | | time to the different activities performed inside a |
| losing money on each coach. Any price above | | | | company (many will use surveys to have the |
| $300 became a contribution to the fixed costs of | | | | workers themselves assign their time to the |
| the company. If the fixed costs were, say, $1000 | | | | different activities). The accountant then can |
| per month for rent, insurance and owner's salary, | | | | determine the total cost spent on each activity |
| the company could therefore sell 5 coaches per | | | | by summing up the percentage of each worker's |
| month for a total of $3000 (priced at $600 each), | | | | salary spent on that activity. |
| or 10 coaches for a total of $4500 (priced at | | | | Each product or service is produced and delivered |
| $450 each), and make a profit of $500 in both | | | | via the activities performed in the company. The |
| cases. | | | | accountant can then assign the different activities |
| Standard costing Standard costing took the idea | | | | to the different products using an appropriate |
| further, by dividing the fixed costs by the number | | | | allocation method. |
| of items produced, and treating the result as if it | | | | A company can use the resulting activity cost |
| were a variable cost. | | | | data to determine where to focus their |
| This enabled managers to effectively ignore the | | | | operational improvement efforts. |
| fixed costs, simplifying the decision process even | | | | For example, a job based manufacturer may find |
| more. | | | | that a high percentage of their workers are |
| For example: if the railway coach company | | | | spending their time trying to figure out a hastily |
| produced 40 coaches per month, and the fixed | | | | written customer order. Via ABC, the accountants |
| costs were still $1000/ month, then each coach | | | | now have a currency amount that will be |
| could be said to incur an overhead of $25 ($1000 | | | | associated with the activity of "Researching |
| 40). | | | | Customer Work Order Specifications". |
| Adding this to the variable costs of $300 per | | | | Senior management can now decide how much |
| coach produced a unit cost of $325 per coach. | | | | focus or money to budget for the resolutions of |
| This method tended to slightly distort the resulting | | | | this process deficiency. |
| unit cost, but in mass-production industries that | | | | Activity-based management includes (but is not |
| made one product line, and where the fixed costs | | | | restricted to) the use of activity-based costing to |
| were relatively low, the distortion was very minor. | | | | manage a business. |
| For example: if the railway coach company made | | | | Marginal Costing This method is used particularly |
| 100 coaches one month, then the unit cost would | | | | for short-term decision-making. Its principal tenets |
| become $310 per coach ($300 + ($1000/100)). If | | | | are: Revenue (per product) - Variable Costs (per |
| the next month the company made 50 coaches, | | | | product) = Contribution (per product) Total |
| then the unit cost = $320 per coach ($300 + | | | | Contribution - Total Fixed Costs = Total Profit / |
| ($1000 /50)), a relatively minor difference. | | | | (Total Loss) Thus it does not attempt to allocate |
| i.e. unit cost is inversely proportional to no. of | | | | fixed costs in an arbitrary manner to different |
| variables. | | | | products. The short-term objective is to |
| Evolution of standard costing As time went on, | | | | maximise contribution per unit. If constraints exist |
| the practice of paying workers on a 'set-piece' | | | | on resources then under marginal costing, these |
| basis changed in favour of paying on an hourly | | | | resources to maximise contribution per unit of the |
| rate. | | | | constrained resource. |
| Organizations with a wide range of products or | | | | Other costing methods More varieties of costing |
| services have many tasks common to several | | | | methods have been proposed in order to tailor |
| finished items,making set-piece impractical. | | | | for different aspects of the business. Some of |
| Costs of materials may vary over time. | | | | the uprising ones include inventory costing |
| Equipment has become more complex and | | | | method, process costing method, average costing |
| specialized and may be a significant variable in | | | | method, target costing method. |
| overhead costs. | | | | Still the standard methods and normal costing |
| Modern companies tend to have relatively low | | | | methods are the best established methods in the |
| truly variable costs (primarily raw material, | | | | accounting world. |